5 Things you Need to Know about Interest Only Loans

Things You Need To Know About Interest Only Loans

Lenders offer a multitude of different loan products for home buyers and property investors. During the last decade the popularity of interest-only loans has risen steadily, particularly with investors.

How is an interest-only loan different?

A basic principal and interest mortgage is broken into two portions: principal – the amount of money you’ve borrowed for the purchase of your property – and interest – the “fee” you pay the lender each month for borrowing their money. With an interest-only loan you pay back ONLY the interest portion for a specific time period.

5 things you should know about interest only loans:

They free up cash flow

Interest-only loans are popular with investors because a lower monthly loan payment can free up cash flow for other investments. This extra cash flow can also be used to pay down higher-interest debt (like credit cards and personal loans), improving your overall financial situation.

They can be tax effective

Only the interest portion of an investment property loan is tax deductable, however the principal payments are not. By using an interest-only loan, repayments are not only lower, they’re also 100% tax deductible.

The interest-only part is for a LIMITED time

Paying only the interest portion of the loan is all well and good, but be aware that this payment option is only available for periods up to 5 years. After the interest-only period expires, the loan converts to a principal and interest repayments and you’ll still owe the sum you originally borrowed. This means that the loan still has to be paid out within the remaining loan period making your repayments higher than if you had just paid P&I from the start.

Success relies on growth in propertyvalue

As you’re not paying down the loan amount during the interest-only period, any equity you gain is via growth in property value. Interest-only loans can be effective during times of high market growth, but if your property stagnates (or declines) in value, you will likely end up out of pocket.

You need to be disciplined to benefit from an interest-only loan

This type of loan can be very effective – if it’s used well. Extra cash flow (the money you would have spent on principal payments) needs to be working for you by either:

paying down consumer debt,

Paying down other debt with a higher interest rate

Sitting in an offset account saving you interest on your owner-occupied home loan.

It’s also worth keeping in mind that it can be very easy to fritter away extra cash – doing so negates the point of using an interest-free loan in the first place so a degree of self-discipline is vital to avoid this pitfall

Listen to George talk about interest only loans (2SSR interview on 17 July 2017)